Exchange Rate Definition
Written by True Tamplin, BSc, CEPF®
Updated on July 19, 2021
Define Exchange Rate in Simple Terms
An exchange rate is a metric by which the value of one currency is compared to another.
It can be thought of as a measure of how much of the second currency can be “bought”with an amount of the first currency.
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What Does Exchange Rate Mean In Finance?
The purpose of an exchange rate is to figure out the buying power of a currency as compared to another currency.
Not all currencies have the same buying power per unit, so knowing the exchange rate helps determine the “value”of an amount of money.
For example, the exchange rate of US dollars (USD) to Pound sterling (GBP) is 1.24.
This means that it takes $1.24 to equal £1.
Put another way, if a US citizen traveled to the UK with $10,000 to exchange into pounds, they would get about £8,034.
Exchange Rate Example
Several factors influence exchange rates.
Most exchange rates are free-floating, meaning they rise and fall in accordance with fluctuations in supply and demand in the foreign exchange market.
Other currencies may be pegged, meaning that their value is tied to the value of another currency within a certain margin; the Hong Kong dollar, for example, is pegged to the US dollar at a range of 7.75 to 7.85, so its value will stay within this range of the USD.
Some currencies have different exchange rates depending on whether or not the funds are held inside or outside a country’s borders.
The Chinese Yuan (CNY), for instance, has an exchange rate of ¥7.05 per $1 outside its borders, but ¥7.04 per $1 inside.